Just Another Day In Paradise For Omega Healthcare

| About: Omega Healthcare (OHI)

Summary

The drama has been unfolding for months as operator pressure within the skilled nursing sector has escalated.

My “back of the napkin” estimate was spot on!

“This is the beauty of a big portfolio, you can sustain.” - CEO of Omega Healthcare.

Yesterday was a tough day for Omega Healthcare Investors (NYSE:OHI), as shares fell more than 7% after the company’s third-quarter results and earnings call. The day-long trading volume (~13 million shares) resulted in a market cap erosion of some ~$2.50 per share, or around $500 million in market value (~197 million shares outstanding).

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Combined with Q1 and Q2, Omega’s Q3 results were just another “day in paradise” for the nation’s largest skilled nursing REIT. So far this year, shares have declined by almost 8%.

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Here’s how Omega’s YTD performance (Total Returns) compares with that of other healthcare REIT peers:

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So where’s the love? Or shall I say lack of love for this prized divided payer?

What Happened?

The drama has been unfolding for months as operator pressure within the skilled nursing sector has escalated. In a recent article, I explained:

“some of the negative news regarding the reliability of future rents and the ability to continue to deliver dividend growth to shareholders significantly overstate the issues that operators are managing through and ignores the enormous demographic wave that seniors that will have greatly expanded healthcare needs over the next 5 years.”

Several skilled nursing operators have experienced pressure, and Omega has three of them in the Top 10:

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On the Q2-17 earnings call, Taylor Pickett, Omega’s CEO, explained:

“3 top 10 operators are responding to information requests made by the DoJ (Department of Justice) 1 top 10 operator is ongoing discussion for the DoJ with respect to potential settlement. At this time, it's too early to determine the outcome of this operator's settlement discussions or any of the other DoJ inquiries.”

As you can see (on the Top 10 list), a new name appears, Orianna, a 42-property operator that was previously referred to as Ark. In a recent article, I explained, “this operator has continued to experience quarterly pressures, despite finally showing signs of operations improvements. As I explained in another article, “My back-of-the-napkin analysis suggests that the worst case for Omega is to reposition all of the Ark properties and rent them out for $35 to $38 million. At the midpoint this re-trade would cost Omega around $.01/share in quarterly FFO.”

Guess what? My “back of the napkin” estimate was spot on! Here’s what Omega said yesterday on its earnings call:

“In the second quarter of 2017, we recorded approximately $16 million of cash and straight line revenue related to Orianna. Placing them on a cash basis and initiating the process of transitioning some or all of their portfolio to new operators required us to test the assets for impairment.

During the quarter, we recorded approximately $204 million of impairments related to our Orianna portfolio, $195 million was to reduce our capital lease assets to their fair value of which $40 million of that change related to writing off the lease amortization or straight-line rent equivalent on the capital lease.

We also recorded $8.2 million in provision for uncollectible accounts to fully reserve Orianna’s outstanding contractual receivables and $1.3 million to write-off straight line receivables related to their operating lease. It’s important to note that Orianna impairment is a subjective estimate and is subject to change based on the final outcome of the transition.

We believe our estimate is conservative based on our current portfolio analysis. The impairment test for a capital lease is different than that of an operating lease.”

In plain English, Omega has stopped paying rent, and the company is transitioning its assets. This means it is negotiating with Orianna, and it could be either a “friendly” resolution or “not-so-friendly” resolution.

The friendly alternative means the landlord and tenant will be able to work out a new master lease, which includes a rent reduction to $32-38 million (an $8-14 million hair cut). Using my back-of-the-napkin math, and using $11 million as the rent reduction, the new “friendly” deal means Omega’s portfolio leased to Orianna is worth around $120 million less now (using a 9% Cap Rate).

If Omega and Orianna are unable to strike a new deal, the “not-so-friendly” alternative is that Orianna ends up in bankruptcy court, at which time the company will eventually take legal possession of the portfolio and find a new operator. Of course, this will take more time to transition, and the process could take up to a year.

Mitigating Risk Is What Separates the Best from the Rest

As mentioned, Orianna operates 42 properties spread across the southeastern U.S. Several of the properties are located in my hometown of Greenville, SC. Click here for the locations.

I have not visited these properties, but it appears that many of the locations are high quality. Here’s an example of one property in close proximity to my office:

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While the Orianna news is not good, it was certainly not unexpected. I am surprised to see the pullback yesterday, given the fact that Omega had already telegraphed the problems on previous earnings calls. But we all know that a “knee jerk” can often lead to opportunity.

Remember, Omega owns a portfolio that includes 1,004 investments (907 operating properties and 90,949 beds):

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In addition to the US properties (around 850 in US), the company also has holdings in the U.K. that consists of 53 care homes across central London and the southern and eastern regions of England.

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As you can see below, Omega’s portfolio generates around $900 million in annual rental income, and the Orianna “hiccup” is around $11 million (as per above), meaning that the loss of income associated with this “transition” is approximately 1.2%.

See what I mean by “knee-jerk” reaction? Shares slide 7%, and the loss of income is just 1.2%.

Also remember, skilled nursing is not the same as net lease. There’s a reason that Omega acquires properties at cap rates of 9-9.5%. It’s a function of risk and return, and when you buy properties to higher-risk tenants, there will always be operators that get into trouble. At the end of the day, the best risk mitigation tool for Omega is summed up in one word: diversification.

Is the Dividend Safe?

As most know, Omega has an exceptional history of earnings and dividend growth. Just take a look at its dividend history below:

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Clearly, Mr. Market is concerned that the operator issues within Omega’s portfolio could lead to a tightening of the payout ratio. Let’s examine the history of the dividends/share:

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As you see, the company has generated very steady and reliable dividend growth, averaging 9.6% annual growth since 2009. On the recent earnings call, Omega’s CEO, Taylor Pickett, said he “remains confident in our ability to pay our dividend, increasing our quarterly common dividend by $0.01 to $0.65 per share.

We’ve now increased the dividend 21 consecutive quarters. Our dividend payout ratio remains conservative at 82% of adjusted FFO and 89% of FAD, and we expect these percentages will improve as the Orianna facilities return to paying rent."

Omega’s revised 2017 guidance reflects the impact of Orianna’s cash accounting and the anticipation that no cash will be received for the balance of the year. Yesterday, Omega said it had lowered 2017 adjusted FFO guidance to $3.27-3.28 per share.

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While this news will impact the dividend cushion, the REIT has been reducing its Payout Ratio for many years in anticipation of a hiccup.

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Omega generates approximately $150 million of cash flow after dividends, and even if the company lost all of the Orianna rental income (~47 million), it is well positioned to weather the storm, and it would have another $100 million of cash flow after dividends.

So What About the Other Operators?

In addition to Orianna, Omega continues to experience specific operator performance issues, as discussed in the last several calls, including Signature Healthcare, another top 10 operator. Similar to Orianna, liquidity issues are impacting the ability of these operators to pay rent on a timely basis.

Signature Healthcare has also fallen further behind on rent in the third quarter, predominantly as a result of anticipated tightening restrictions upon its borrowing base by its working capital lender, thus reducing availability. The vast majority of Signature’s past due rent balance is covered by a letter of credit in excess of $9 million.

Keep in mind, Omega is continuing to grow its platform. The company said it had completed two new investments totaling $202 million, plus an additional $36 million of capital expenditures. Specifically, it completed $190 million purchase lease transaction for 15 skilled nursing facilities in Indiana, and as part of that same transaction, simultaneously completed a $9.4 million loan for the purchase of the leasehold interest in one skilled nursing facility with an existing Omega operator.

Omega is well positioned to grow, as the company has approximately $910 million of combined cash and revolver availability to fund future investments and provide capital funds to the existing tenant base. The balance sheet remains exceptionally strong. For the three months ended September 30, 2017, net debt-to-adjusted annualized EBITDA was 5.46x and the fixed charge coverage ratio was 4.2x.

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As noted above, diversification matters, and Omega is in excellent shape to continue to diversify its holdings. I consider the strength of the balance sheet and exceptional diversification to be the biggest risk mitigators for the company to insure the safety of the dividend and to protect the future profits of the enterprise.

OHI can still make accretive investments today (~9% cost of equity / ~5% cost of debt), which, at 60/40 (equity/debt), generates 100 to 150 bp spread to acquisition yields. Combined accretive investments and active portfolio recycling could mitigate skilled nursing industry pressures on earnings.

I’m Maintaining a Buy

Yesterday, I spoke with Omega’s CEO, and I’ll provide you with a few of his comments:

“This is the beauty of a big portfolio, you can sustain”.

“The dividend is completely secure with room to grow it”.

“The dividend is pretty attractive as you want on demographics”.

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He’s right - 8.4% is a decent dividend yield to get while you’re waiting.

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There’s no question shares are cheap...

Could they get cheaper?

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Sure. But it simply boils down to managing risk, and the primary reason that I am hanging onto my shares in Omega is because I believe in the management team. Companies aren’t going to bat 400 every quarter, and when I see a “knee jerk” like I saw yesterday, I am reminded that there is always a silver lining. That’s what the other Buffett (Jimmy) means when he sings, “It’s just another day in paradise.”

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Note: Brad Thomas is a Wall Street writer, and that means he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and be assured that he will do his best to correct any errors, if they are overlooked

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Sources: F.A.S.T. Graphs and Omega Investor Presentation.

Other REITs mentioned: LTC Properties (NYSE:LTC), Ventas, Inc. (NYSE:VTR), Welltower, Inc. (NYSE:HCN), National Health Investors, Inc. (NYSE:NHI), HCP, Inc. (NYSE:HCP), Senior Housing Properties Trust (NYSE:SNH), Global Medical REIT, Inc. (OTC:GMRE), Medical Properties Trust (NYSE:MPW), Healthcare Trust of America (NYSE:HTA), Healthcare Realty Trust (NYSE:HR), Physicians Realty Trust (NYSE:DOC), New Senior Investment Group (NYSE:SNR), Sabra Health Care REIT (NASDAQ:SBRA), OHI, Community Healthcare Trust (NYSE:CHCT).

Disclosure: I am/we are long APTS, ARI, BRX, BXMT, CCI, CHCT, CIO, CLDT, CONE, CORR, CUBE, DLR, DOC, EPR, EXR, FPI, GMRE, GPT, HASI, HTA, IRM, JCAP, KIM, LADR, LAND, LMRK, LTC, MNR, NXRT, O, OHI, OUT, PEB, PEI, PK, QTS, RHP, ROIC, SKT, SPG, STAG, STOR, STWD, TCO, UBA, UNIT, VER, VTR, WPC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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